What is a Loan

What is a loan?

A loan is a legal binding agreement between the lender and the borrower. These agreements usually involve the lender (usually a bank or another financial institution) disbursing X amount of dollars with the understanding that the borrower will pay the full principal amount back in full with any interest that is accumulated throughout the duration of the loan.

Now before taking out a loan, there are things that you must consider. Depending on your current situation, there could be many things to consider such as:

– Whether you want a short or long term loan?
– Whether to amortize your loan?
– Whether to be locked in at an interest rate or not?
– What Collateral do I have?

With many loans that people receive, borrows have to make a decision whether they want to pay back their obligation in the short or long term. Now there are advantages and disadvantages to both. While a short-term loan will obviously pay off the principle much faster and decrease the amount of interest paid, the monthly payment will higher depending on how much your principal is. Long Term loans are less stressful, speaking from personal experience. The monthly payments are little bit more relaxed therefore it is not burning a hole in your pocket every month. However the disadvantage is that you pay the financial institution back almost double than what you borrowed. Long term loans are for major purchases such as a house or a business that you know you will need the long term to pay it off. A short term loan can be categorized as a loan agreed to less than 10 years and a long term loan agreed to over 10 years.

As with most loans you will mostly always have the option of amortization. This means that you pay a fixed amount over a predetermined amount of time. Amortization is more frequently found when a person borrows a significant amount of money and engaged in a long term loan, usually for a car or a house. When you finalize your loan with amortization, your financial institution will tell you exactly how long your loan will be, how much per month you pay as well as the total interest that you will have paid. Amortization is a fixed loan that leaves the borrower with some sort of security that their loan is controlled.

Sometimes when you go into a financial institution for a loan, they will give the option to lock into an interest rate. There are many advantages to locking in as well as disadvantages. The advantages and disadvantages are pretty straight forward simple. If you lock in and the interest rates rise your rate does not. However if you are not locked in and the interest rate lowers will pay the new lower rate, but will still pay higher if your locked in. So as you can see being locked in or not is kind of a gambling situation unless you are good with the markets and can forecast these changes before they happen.

With some loans that you get, the bank or financial institution will most often ask for collateral in exchange for the loan. Collateral is a security for the bank or institution. Collateral can be anything that is of major value, such as a car, house or other valuable securities that you posses like diamond jewelry etc. How collateral works is that if you fail to make payment on your loan, the bank uses your collateral that you give them and sells it to make the money back that you have failed to pay. When buying a house, the house is automatically collateral which means the bank owns the house even though you are living in it. If you fail to make payment then the bank forecloses on or resells the house and you lose all the payments that you already made.

So as you can see there are some very important considerations and decisions to make before you take out any kind of loan whether it is for the short or long term. Failure to pay back loans will drastically have a negative impact for the rest of your financial life and could prevent you from ever getting a loan again. Take time to think, plan and prioritize before signing on the dotted line.